Congress eyes tax changes benefiting S corporations.

One of 22 changes would increase number of shareholders

Small businesses may get an added edge to attract investor capital if legislation recently proposed by U.S. Sens. David Pryor, D-Ark., and John Danforth, R-Mo., is passed to revamp the part of the IRS code governing S corporations.

S corporations were created in 1958 to help entrepreneurs and small businesses by making shareholders responsible for paying taxes on all corporate profits. In this way, S corps avoid the double taxation burdening most other corporations, whereby both corporate profits and shareholders' dividends are taxed.

But, over the years, other rules for S corporations have stymied capital-raising by limiting the number of stockholders an S corporation can have and limiting participation to U.S. residents and for-profit companies. The 22 changes in the proposed legislation would boost the number of permitted stockholders from 35 to 50, permit non-residents and non-profit agencies to invest in S corps, and count all related shareholders as a single shareholder.

Sources said the proposed changes will be voted upon by the fall 1994.

"I'm all for it," said William Greene, managing shareholder of a Burbank-based S corporation called Sports Tutor Inc. "It's long overdue."

Greene said his business, which manufactures machines that toss tennis and whiffle ball-like balls, has "lost out on potential investment money because of gray areas in the tax law."

He said he is particularly happy about the higher, 50-shareholder cap. "Even if you can get $10,000 from each shareholder, 35 (shareholders) is only $350,000, and it takes a lot more than that to start up some businesses."

S corp shareholder Thomas Tustin, who owns and manages Santa Fe Springs-based SE Pipeline Inc., which constructs oil and natural gas pipelines, said the changes would provide a way to "give my employees a piece of the action as an incentive."

Dave Daley, a partner in the downtown L.A. office of accounting firm Arthur Anderson & Co., echoed those sentiments. By allowing non-profit corporations to participate, said Daley, "you can allow pension funds and employee stock ownership plans to be shareholders in an S corporation."

Daley also noted the reassessment of related shareholders would be "helpful to a lot of family-owned businesses that have been around for two or three generations and, therefore, have a lot of potential shareholders."

His enthusiasm is shared at other L.A. accounting firms. "I have a lot of clients that are married to resident aliens," noted George McCrimlisk, partner at the downtown L.A. office of KPMG Peat Marwick. Both the U.S. citizen and the resident alien spouse are shareholders in an S. corporation, he said. The way the rules are written now, said McCrimlisk, "if the U.S. citizen dies and the non-citizen gives up residency in the U.S., the S corporation loses its status as such."

If the new provisions are enacted, the non-resident alien could continue to be a qualifying shareholder.

For Philip Strauss, a tax partner at Coopers & Lybrand's downtown L.A. office, this provision would prove helpful to one of his S corporation clients who has access to foreign capital. Strauss also sees potential in lifting the ban on non-profit corporations' participation.

"For one client," said Strauss, "the shareholder could transfer stock to a charitable remainder trust and get a tax deduction, and the corporation would still maintain its S corporation status."

Another positive step, said the accountants, is a proposed change in the way the government categorizes convertible debentures and preferred stock issues. Right now it considers them as non-allowable equity as soon as they hit the books, which, said one CPA, "would blow your S corporation election."

The proposal would treat both of these investments as debt for tax purposes, and thus open the door to using additional capital instruments.

Tustin, who claimed to have no problem getting financing, saw the preferred stock option as a way to reward SE Pipeline shareholders who "might be retiring from active service."

Strauss said he also foresees using this provision as an effective estate-planning tool. "Many of our S corporation clients are family businesses, and this would give them a means of transferring wealth to future generations while retaining control of the corporation."

To Daley, the provisions would "accelerate capital formation by making it easier to invest in S corporations and preserve family businesses. Other provisions would, he said, "eliminate traps for the unwary."

An example of one of these traps, he said, would be the invalidation of S corporation status due to little oversights, like neglecting to have appropriate signatures on an application form. The proposal offers ways to correct these oversights so that the S corporation status can be maintained.

McCrimlisk also applauded a provision to let S corporations own subsidiaries, particularly since one of his clients, an S corporation manufacturer that sells products through various dealers, would directly benefit from the change.

"To insulate assets from potential liabilities, the manufacturer may want to form a new subsidiary to conduct dealership activities through," McCrimlisk explained. "The rules now preclude that manufacturer from owning 80 percent or more of the subsidiary."

Strauss also said he sees this provision as a means for S corporations to make acquisitions without incurring liabilities for the entire S corporation.

But one thing that the proponents have left out, said S corp shareholder Greene, is a deduction for health care expenses. Right now, S corporations, unlike other businesses, cannot deduct the expense of health care plans for their employees. In this way, said Greene, "you're really penalizing businesses for being S corporations."